Monday, July 25, 2016

When two of the biggest US pension funds reported very disappointing financial results this month, it became apparent that the pension industry needs a reality check. For the past fiscal year the California Public Employees’ Retirement System earned a merger return of 0.6 percent on its investments; the California State Teachers' Retirement System did only marginal better, clocking an investment return of 1.4 percent. Both funds had a target rate of return 7.5 percent . To be fair, one year`s result does not make a trend, but the results were so far below target as to warrant an examination of the new world confronting pension fund managers.

Underfunding of Public and Private Funds

We begin by taking the measure of how far public pension funds (Chart 1) and corporate pension funds (Chart 2) are underfunded. Underfunding is a moving target over time and is reflective of several moving parts, such as : shifts in demographics (an aging population); estimates of longevity of retirees; economic performance (slow growth means lower contributions); and rates of return on various asset classes. In the US, both public and private pensions have experienced a steady erosion in funding status over the past decade and a half. The large public pension plans and large corporations only support 75-80 percent of liabilities today. The underfunding exists despite a very good rate of growth in total assets under management; however, liabilities have increased faster and one reason for this can be traced to the dramatic fall in long term interest, especially, post 2008.

The decline in interest rates affects both sides of the ledger. On the asset side, lower interest rates imply lower overall returns; on the liability side, the book value of pension obligations move up due to the lower discount rate used to calculation the liabilities. In fact, these two changes in value --- assets and liabilities-- do not offset one another, rather they move in the same direction. The net affect is that the underfunding situation is exacerbated, increasing the gap between assets and liabilities. More worrisome is that pension funds will have to replace higher-yielding bonds with lower-yielding bonds over time. This concern is especially acute in the UK ,Germany and other EU countries as bonds yield sink into negative territory , thereby reducing the size of bond market in which pensions can particpate . The tightening of the supply of positive-yielding bonds is becoming a very real problem today, let alone in the coming years. (http://soberlook.com/2016/07/the-looming-shortage-in-government-bonds.html)

Overall rates of return earned in the pension industry throughout the developed world have steadily fallen, resulting in a relative weak performance in asset accumulation .A recent OECD study measured the rates of return over 5- year and a 10 -year periods. (Chart 3). Nominally, the US (3 percent) has underperformed its peer group in the UK (9 percent) and Canada (6 percent); all countries have experienced weak results over a 10- year period. These relatively low rates of return are at the heart of the issue facing the industry: namely, are the targets set too high?

What does it take to earn 7.5% ?

The vast majority of the US pension industry clings to investment targets of 7-8 percent annually. True, this is an expectation over an average of 5 years as the industry must live in a world of high volatility. Yet, how realistic is this target? Lets look it at from a macroeconomic perspective. A nominal return of 7.5 percent implies that national income --- wages, profits-- should, on average, grow at 7.5 percent. That is, the national income growth should be about 5 percent real growth plus 2.5 percent inflation. Neither that real growth rate or that inflation rate has been achieved on a sustained basis over the past decade. Moreover, mainstream economists do not anticipate that the US economy will achieve real growth rates of 5 percent in the coming years; continued moderate real growth of 2-3 percent is anticipated ; and inflation expectations remain very subdued, as evidenced by the low long term interest rates. So, from a macro perspective, the 7.5 percent target is hard to justify. The industry needs to generate rates of return well in excess of the economy`s capacity to create income growth.

Considering the target from a microeconomic perspective, the target seems even more illusive. Table 1A presents the findings of the OECD study on the composition of assets in the majority of large pension funds. The funds continue to rely on the "traditional" assets of government and high quality corporate bonds (50-55 percent) and publicly traded equities (20-25 percent) of all pension fund assets. In recent years, the funds sought to enhance yields--- the so-called 'search for yield'-- by investing in commodities, private equity funds, hedge funds. commercial real estate and large infrastructure projects. These " alternative " assets account for about 12-15 percent of total assets under management. However, these alternative investments can and have been very volatile, e.g. commodities, and some of the large funds have dropped that category from their investment basket.

Table 1B considers what the growth rates of the various asset classes needs to be in order to generate an overall growth rate of 7.5 percent. Clearly, all asset classes must grow at quite high rates in order to reach the overall target. Equities need to average a growth rate of 15 percent annually, bonds need to return 4 percent a year, and more importantly alternative asset classes have to clock in at rates of 12 percent a year to help achieve the overall investment target.

The most important asset class--- US Treasuries-- has suffered the most as illustrated in Chart 4. As yields in Treasury yields continue to fall since 2011, the spread between Treasuries and target returns has widen. This puts additional pressure on fund managers to seek higher yields in the non-traditional asset groups, especially in commodities and hedge fund activities-- both of which are very volatile and risky. All the while, the funds cannot run afoul of the regulatory authorities who have to safeguard current and future retirees` income.

Pension fund managers are caught between a rock and hard place . Many US state plans are forced to meet the underfunding issue by increasingly relying on tax receipts to top up funds at the expense of other basic state obligations such as public education. With each passing year, the shortfalls increase, yet the state needs for other obligations continue to climb. Thus the short falls come at a considerable cost to the nation.

Some public funds, such as the Canadian Pension Plan, have invested in long term infrastructure projects at home and abroad as a means of boosting returns. Such opportunities are far and few between. In the US, many pension plans have invested in hedge funds and a variety of financial derivatives as a way to overcome low yields from traditional assets. Nonetheless, this search for yield does not move the needle sufficiently to allow the pension funds to meet their targets.

By no means is this situation confined to the US. The British pension industry has been underfunded for sometime, and the situation became a whole lot worse following the Brexit vote. UK interest rates fell significantly since the June vote, applying more pressure on managers to correct underfunding. Finally, the wave of negative interest rates in Germany and other EU countries have made pension managers` lives a lot more difficult in their search for positive- returning assets.

What does the Future Have in Storefor Pension Funds

The OECD study does not mince words. It states `` to reduce insolvency risks, insurers may need to offer lower guaranteed
returns on new contracts to reduce liabilities and, in extreme cases,
renegotiate current terms. Pension plan sponsors could adjust or terminate
existing plans and offer less attractive terms to new employees. Defined
benefit pension plan sponsors could increase contributions to funds. Regulators
and policy makers will need to remain vigilant to prevent excessive “search for
yield”, (1)

Implicit in this report is the recognition that slow global income growth and low interest rates will dominate the international community and historic investment targets are not expected to be repeated. Thus, we can anticipate a number of changes in the industry, including: the demise of the defined benefit program; younger members having to pony up more in pension contributions; taxpayers topping up state plans; a continual re-assessment of longevity risks; and an downward adjustment to overall investment targets. These changes amount to a significant adjustment to the parameters that guide pension funds going forward.

Saturday, July 16, 2016

Ever since the 2008 financial crisis, there has been a persistent shortage of high-quality government debt. More than just a safe haven in times of financial stress--- the so-called 'flight to quality' -- the supply of high- quality sovereign debt has been steadily shrinking. This shortage became acutely apparent with the results of the Brexit referendum as investors worldwide bid up bond prices to the point where most long term bond yields reached historic lows in the US, UK , Germany and Japan. Brexit only exacerbated a shortage problem that bond investors have had to contend with for nearly a decade. The current squeeze in supply is just the latest manifestation of this wider issue in today's financial markets.

To claim that there is a shortage of government debt must seem counter-intuitive to many readers. After all, there is no end of studies demonstrating that major economies have record high government debt-to- GDP ratios, signifying that there is too much debt, not too little. Many critics call for governments everywhere to issue less debt, arguing that such high levels of debt ratios contribute to sluggish growth, if not, outright stagnation. European governments continue to exercise spending restraints and, in general, austerity is the byword throughout the industrialized world. Governments have been very reluctant to open up their coffers by issuing more debt to fund expenditures.

However, a case can be made for more government debt. In a recent article, The World Needs More U.S. Government Debt former FOMC member, Narayana Kocherlakota argued this case, succinctly, when he wrote:

But scarcity is not about supply alone. In the wake of the financial crisis, households and businesses are demanding more safe assets to protect themselves against sudden downturns. Similarly, regulators are requiring banks to hold more safe assets. Market prices tell us that the government needs to produce more safety in order to meet this increased demand. ........ The inadequate provision of safe assets also has profound implications for financial stability. Without enough Treasury bonds to go around, investors “reach for yield” by buying apparently safe securities from the private sector ...if such behavior becomes widespread, it can create systemic risks that tip the financial system into crisis.

To better understand how bonds became scarcer, we begin by looking at who is buying government debt and why.

The Expanding Role of Central Banks

As the Federal Reserve sought ways to stimulate the economy, it became the first major central bank to start a bond-purchase program-- Quantitative Easing (QE) Soon after the Bank of England (BoE) , the Bank of Japan (BoJ) and most recently the European Central Bank (ECB) developed their own versions of QE. ( Chart 1). The US Fed holds nearly 20 percent of all Federal government debt; the BoJ owns over 30 percent ; the BoE, 25 percent; and, the ECB has so far bought about 15 percent of German debt. The Fed is no longer purchasing debt, while the other central banks continue with their QE programs.

The Fed increased its balance sheet dramatically from about $800 billion to over $2.4 trillion under three QE programs . Although the Fed no longer actively purchases government bonds, it appears in no hurry to release those bonds into the marketplace, instead allowing the bonds to mature fully over time.

Over 40 percent of outstanding US Treasuries are held by foreign central banks , sovereign wealth funds and other institutions. China and Japan together account for about 12 percent. As the US runs current account deficits with its major trading partners, the excess in US dollars are re-cycled into purchases of US Treasuries. More importantly, many central banks , especially, those in emerging countries have purchased Treasuries in increasing amounts and holding them to shore up their balance sheets and to provide needed foreign exchange reserves. In sum, Treasuries are been soaked up by US domestic and foreign entities as part of a worldwide push to strengthen balances in the private and public sectors in the wake of the 2008 financial crisis.

The ECB and the BoJ both continue with very aggressive bond purchasing programs. The BoE may be forced to expand its current program in response to the fallout from UK voters opting to leave the EU. The ECB came late to the game of bond purchases, starting in 2015, some six years after the US first implemented QE. Initially, the ECB embarked on a program of purchasing government debt at a rate of 50 billion euros per month. But as the supply of qualified government debt diminished the ECB increased its bond purchasing program to included corporates . Overall, the ECB program now soaks up about 80 billion euros a month of high quality debt . Speculation is ripe that the ECB will do more bond purchasing in the wake of the Brexit vote. Turning to Japan, the BoJ has long been a huge purchaser of domestic government bonds( JGBs) .Over the next four years, the BoJ is expected to own over 60 percent of all outstanding JGBs, the highest of any country.

Growing Domestic Needs for Treasuries

Domestically, major holders of Treasuries include Federal government and state / local pension plans ( Table 1). These plans will require additional risk-free Treasuries to meet longer term obligations. US charted banks have significantly increased their holdings of Treasuries and Agency debt as a means of strengthening their balance sheets. From 2013 to the present , commercial banks increased holdings of Treasuries by 30 percent .Finally, private pension funds and the life insurance companies hold approximately 6 percent of their assets in Treasuries. Industry analysts argue that proportion is inadequate to meet future liabilities and it is expected that these institutions need to double their holdings to satisfy future income requirements. In short, government bonds will be a strong asset class from here on out as these institutions re-balance their portfolios to meet long run requirements.

The Phenomenon of Negative Interest Rates

One does not have to look any further than the exploding market for negative interest rate bonds to find convincing proof of a bond shortage . Today negative interest rate bonds total over $US12 trillion in Europe and Japan ( Chart 2). More importantly, the average duration of these bonds has increased remarkably just within the past year. Negative yields extend out to 10+ years in Germany, 15 years in Japan and even as far as 30 years in Switzerland . ( http://soberlook.com/2016/04/understanding-negative-interest-rates.html)

Not surprisingly, central banks themselves are having trouble finding all the bonds they need. For example ,the ECB is not permitted to buy bonds with a yield lower than its deposit rate of minus 0.4 percent, thus excluding many billions of euro-dominated bonds issued by Switzerland, Germany, France , Netherlands and Sweden. In other words, there is a real squeeze on positive-yielding safe haven bonds.

Vanishing Credit Quality and Liquidity

Since the emergence of the debt crisis in Europe starting in 2012, there has been a wave of national debt downgrades .The Bank of America Merrill Lynch estimates that the share of bonds with the three highest credit ratings has dropped to 51percent of all debt tracked by the bank’s world sovereign bond index from 84 percent in 2011. With so many institutions restricted from purchasing anything less than high quality bonds, managers are facing a smaller and smaller market in which to participate. Credit worthiness comes into play in the very large repo loan market where high quality debt is used as short term collateral by hedge funds, money markets, private equity and other lending groups. It is estimated that the volume of repo loans using Treasury debt has nearly halved since the financial crisis of 2008.

On the issue of liquidity, there have been system wide reductions, even in the case of the US Treasury market, considered to the most liquid of all bond markets. Regulatory changes post-2008 have made bond dealers less willing to hold inventory and facilitate trades. Bond trading desks have slashed inventories in response to regulations such as Basel III and the Volcker Rule. Hence, primary dealers have reduced their U.S. debt holdings by as much as 80 percent according to Bloomberg. com estimates.

These liquidity developments have prompted Barry Eichengreen of UC Berkeley to argue that ``international liquidity has plummeted from nearly 60 percent of global GDP in 2009 to barely 30 percent today.`. Recent auctions for US Treasuries feature large oversubscriptions, and this has driven yields lower. There is more than just a temporary flight to safety to quality debt; there appears to be a major shift in asset preference in favour of high-quality debt issued by the US and other major countries at a time when the supply of that debt is not keeping with demand.

Outlook for Supply

In a recent report , Bank of America Merrill Lynch said that "the world is running out of positive-yielding safe-haven bonds’’. The looming shortage has implications in many segments of the fixed income market. Every indication points to a worsening of the supply shortage of high quality bonds. In the US, the 2016 Federal deficit is expected to be lower than the previous year by some 25 percent. To finance this lower deficit, the Treasury has opted to issue more bills instead of bonds as a means of lowering interest costs .This combination will exacerbate the shortage situation and will most likely keep long rates down at these current levels.

In Europe, the ECB is running out of qualified government bonds to purchase in the wake of a growing segment of the market having gone deep into negative territory. It has had to resort to buying corporate bonds to satisfy its purchasing objectives. There is no sign that Euroland will ease up on its austerity program and we can expect a tight supply of new government issuance in 2016-17. Japan continues to wallow in deflation and the BoJ is continues to be under pressure to step up its bond purchasing program, driving longer dated yields ever lower. From a supply perspective alone, we can expect that long term rates will be kept at these historic low levels.